Using the Accounting Equation: Adding Revenues, Expenses & Dividends

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  • 0:05 Basic Equation to…
  • 0:34 The Basic Equation
  • 2:19 The Extended Equation
  • 3:36 How the Extended…
  • 6:22 Lesson Summary
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Lesson Transcript
Instructor: Rebekiah Hill

Rebekiah has taught college accounting and has a master's in both management and business.

Accounting is built on a solid foundation called the basic accounting equation. In this lesson, you're going to learn what happens when you add revenue, expenses, and dividends to the basic equation.

Basic Equation to Extended Equation

Have you ever seen a house being built? It's pretty amazing. The contractor starts with a basic foundation and keeps building on that. He adds walls, ceilings, floors, and a roof. Before long, the house is complete. Accounting concepts are a lot like that. It starts with a basic accounting equation, and before you know it, more concepts are being added. In the end, you have an extended accounting equation.

The Basic Equation

The foundation of the entire accounting process is built on the one simple equation. That equation, called the basic accounting equation, shows the relationship that exists between assets, liabilities, and owner's equity. Assets are the things that you own. Liabilities are the things that you owe. Owner's equity is the amount of money that a business owner or owners have personally invested in a company.

The basic equation states that assets = liabilities + owner's equity. Simply put, this equation means that in order for the company to have balanced finances, the total of all its assets must be equal to the sum of the total of its liabilities and owner's equity. That's saying a mouthful, isn't it? Let me use an example to help you understand.

Barbara is a hairdresser. She rents the building that her salon is in, but she owns all of the equipment. Barbara has $1,500 in the bank. The total value of the equipment that Barbara owns is $15,000. Her annual expenses are $12,000, and the amount of equity that she has in the business is $4,500. Using the basic accounting equation, let's see if her finances are balanced.

Assets = liabilities + owner's equity

$1,500 in the bank + $15,000 value of equipment = $12,000 in annual expenses + $4,500 of personal investment Barbara has in the business
$16,500 = $16,500 - Yep, her finances are balanced.

The Extended Equation

But things aren't always as cut and dry as this information that we had on Barbara. The majority of the time, there are more components that have to be considered. What about the money that Barbara makes fixing hair? That has to have an accounting classification. Or, what about more expenses that she may have? They have to fit into this equation somewhere.

And what happens if Barbara decides that she wants to branch out into the hair design arena? She may have to have investors to do so. Well, those investors, or the people who loan Barbara money for expansion, they want to get something in return. Let's decide what other accounting classifications fit the bill.

Money that's brought in as payment for goods or services is called revenue. The money that is paid out of a company for items necessary for daily operation is called expenses. The money that's paid to investors as a return on their investment is called dividends. When you add those three accounting classifications to the basic accounting equation, you have something called the extended equation. The extended accounting equation is nothing more than the basic equation with the owner's equity section broken down into the three categories of revenue, expenses, and dividends.

How the Extended Equation Works

The actual formula for the extended accounting equation states that:

assets = liabilities + (revenue - (expenses + dividends)).

In reality, this concept is just as simple as the basic equation. Assets are still assets, and liabilities are still just liabilities. It's the added step of breaking down the owner's equity into the revenue, expenses, and dividends that makes this a little bit more time consuming. To make it easier, just remember that owner's equity = revenue - (expenses + dividends). Let's talk about Barbara again.

One day, Barbara decided that she wanted a special kind of scissors to use in her salon. She couldn't find what she wanted, so she drew up her own design and had a friend make them for her. The scissors were fantastic. She showed them to a few cosmetologist friends of hers, and they each wanted a pair. Barbara decided that she should get a patent on the scissors and then start a business making them.

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